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An admission by Athens that it will miss its deficit target of 7.6 percent this year reignited worries about a Greek default. The price of U.S. crude oil tumbled 2 percent, while a bid for safety stoked demand for U.S. Treasury debt.

Major U.S. stock indexes fell more than 2 percent, with financial shares hard hit on a new round of concerns over Greek debt, eclipsing an early boost from better-than-expected U.S. manufacturing data.

Bank shares were also battered in Europe as investors feared they may have to make further write-downs on Greek debt holdings. French-Belgian financial group Dexia (DEXI.BR) shares slumped 10 percent as its capital position looked increasingly stretched by its exposure to Greece.

Athens, in a draft budget sent to parliament on Monday, forecast a deficit of 8.5 percent of gross domestic product for 2011.

"This news isn't surprising, but if Greece continues to have problems, that could really drag Europe into recession, and possibly the U.S. as well," said Randall Warren, chief investment officer of Warren Financial Service in Exton, Pennsylvania.

European policymakers appeared no nearer to agreeing on a definitive solution to the crisis. Officials meeting on Monday were discussing ways to leverage the bloc's rescue fund and pressure Greece to implement agreed structural reforms.

"Ultimately, Greece would need to see its debt written down by more and with that you need probably some kind of shoring up of the banking sector," said Alec Letchfield, chief investment officer at HSBC Asset Management.

U.S. stocks extended losses in the afternoon, with the S&P 500 falling to a 13-month low. The KBW bank index .BKX fell 4.78 percent, with Morgan Stanley (MS.N) shares down 7.6 percent and Bank of America (BAC.N) down 9.6 percent. On Friday, stocks closed their worst quarter since 2008.

The Dow Jones industrial average .DJI closed down 258.08 points, or 2.36 percent, at 10,655.30, while the Standard & Poor's 500 Index .SPX fell 32.19 points, or 2.85 percent, to 1,099.23. The Nasdaq Composite Index .IXIC lost 79.57 points, or 3.29 percent, to 2,335.83.

The MSCI All-Country World index .MIWD00000PUS fell 2.9 percent to its lowest level since July 2010. The FTSEurofirst 300 .FTEU3 of top European shares ended 1.2 percent lower.

The October-December period is, traditionally, the best quarter for equities. Reuters data shows that since 1971, world stocks have on average risen 3.7 percent in the fourth quarter.

Dexia closed 10.16 percent lower after credit agency Moody's announced a rating review for possible downgrade on concerns about liquidity. Dexia called an emergency board meeting on Monday, a source familiar with the matter told Reuters.

Belgian and French finance ministers were also meeting with other euro zone leaders on Monday evening. The Belgian finance minister, Didier Reynders, said the two states, as well as Dexia shareholders, would do all that was required to support their banks.

The euro hit an 8-1/2-month low of $1.3185. Against the safe-haven yen, it lost 1.76 percent to 101.11 yen, its lowest since May 2001 according to Reuters data.

"Euro zone bank issues remain a big issue, and we expect the euro's downside to continue," said George Saravelos, G10 FX strategist at Deutsche Bank.

The benchmark 10-year U.S. Treasury note gained 49/32 in price, driving its yield down to 1.7492 percent. Treasuries prices were also supported by the Federal Reserve's first bond purchase for Operation Twist, its latest program aimed at helping the U.S. economy.

U.S. crude oil prices settled down $1.59 at $77.61 a barrel, the lowest closing price in more than a year.

Gold rose 1.6 percent, its biggest one-day gain in a month, as the safe-haven bid returned. Spot gold rose to $1,649.30 an ounce and U.S. gold futures for December delivery settled up $35.40 at $1,657.70 an ounce.

But markets were closed in No. 2 gold consumer China for a public holiday and trading volume was half its 30-day average, suggesting the metal's rally could easily run out of steam.

(Additional reporting by Ryan Vlastelica and Frank Tang in New York, Natsuko Waki in London; Editing by Dan Grebler)

Corrects lead to say 15-month low, not 2-year low.

The Institute for Supply Management said on Monday its index of national factory activity rose to 51.6 last month from 50.6 in August.

September marked the 26th straight month of expansion in a sector that has shouldered the broader economic recovery and the factory report implied the an outright contraction in output would probably be avoided.

Economists had expected the index to edge down to 50.5. A reading above 50 indicates expansion manufacturing.

"Manufacturing is not falling off a cliff. Again this is not an indicator that points to a U.S. recession without a much bigger shock out of Europe," said Alan Ruskin, a currency strategist at Deutsche Bank.

U.S. CONSTRUCTION EXPANDS ALSO

A separate report from the Commerce Department showed an unexpected rebounded in construction spending in August as outlays on state and local government building projects rose sharply.

Construction spending rose 1.4 percent to an annual rate of $799.15 billion, the Commerce Department said. Economists had forecast a 0.3 percent drop.

Stock indexes cut their losses on the data, while prices for Treasury debt pared gains. The dollar trimmed gains versus the euro.

Data last week showed that cash-rich businesses continued to invest in machinery, a trend that economists expect to hold and keep the economy expanding despite a pull back in consumer spending because of weak income.

Manufacturing accounts for about 12 percent of gross domestic product and almost 11 percent nonfarm employment.

The tenor of the manufacturing report was strengthened by a an increase in hiring last month, which could be a good omen for Friday's employment report.

The economy failed to add jobs in August, leaving the unemployment rate at a lofty 9.1 percent.

Other details of the factories survey showed production rebounding last month after contracting in August. However, new orders contracted for a third straight month, potentially pointing to a pull back in manufacturing in the months ahead.

But inventories are growing at a slower pace and the ISM viewed customers' supplies as too low, which is should boost future orders.

(Reporting by Lucia Mutikani and David Lawder)

The gloomy news from Athens brought the specter of a debt default closer and will weigh on talks among euro zone finance ministers in Luxembourg later on Monday on the next steps to try to resolve the currency area's sovereign debt crisis.

European bank shares suffered the heaviest falls on fears that private sector bondholders may be forced to absorb bigger losses than agreed in a July rescue plan for Greece, which was based on more optimistic growth forecasts.

Draft budget figures issued on Sunday showed the deficit would be 8.5 percent of gross domestic product this year, well above the 7.6 percent agreed in Greece's EU/IMF bailout program, and 6.8 percent in 2012, short of the 6.5 percent goal because the economy will shrink further.

Deputy Finance Minister Pantelis Oikonomou played down the shortfall, saying European Union and International Monetary Fund inspectors had "essentially concluded" negotiations to give Greece a crucial 8 billion euro installment of aid this month to avert bankruptcy.

However, a source familiar with the review by the "troika" of international lenders said the talks were not over, and the inspectors were still examining both the budget numbers and other reforms required for the loan disbursement.

The 17 euro zone ministers will not take any decision on Monday on releasing the funds, needed to pay October salaries and pensions, since the troika has yet to report back. They are set to decide at a special meeting on October 13.

The disclosure that Greece's funding needs next year will be greater than forecast when a second 109 billion euro rescue package was agreed in principle in July reopened a fraught battle over who should pay -- taxpayers or financiers.

Deutsche Bank chairman Josef Ackermann, head of the International Institute of Finance (IIF), which negotiated a "voluntary" bond-swap by investors as part of the bailout plan, warned at the weekend against changing the terms now.

"If we reopen the voluntary accord of July 21, we will not only lose precious time but quite possibly also private investor support," Ackermann told the Sunday edition of Greek newspaper Kathimerini.

"The impact of such a move will be incalculable. This is why I am warning in the most forceful way against any material revision," he said.

Private bondholders agreed to a 21 percent write-down on their Greek debt holdings but EU and German officials have suggested the "haircut" may have to be increased in light of the new funding shortfall and changed market conditions.

"Ultimately, Greece would need to see its debt written down by more and with that you need probably some kind of shoring up of the banking sector," said Alec Letchfield, chief investment officer at HSBC Asset Management.

Political resistance to pouring more public money into euro zone bailouts is growing across northern Europe.

"Greece is bankrupt," said Michael Fuchs, a deputy parliamentary floor leader in German Chancellor Angela Merkel's Christian Democrats, reflecting a growing mood in Berlin.

"Probably there is no other way for us other than to accept at least a 50 percent forgiveness of its debts," Fuchs told the Rheinische Post newspaper.

FLIGHT TO SAFETY

Uncertainty over the extent of damage to the already fragile European banking sector from a possible Greek default has been driving investors to take refuge in safer assets.

Yields on Spanish and Italian government bonds rose and the cost of insuring their debt against default spiked on the news from Greece, while money poured into safe-haven German Bunds. The euro also fell to an eight-month low in Asia.

"The markets continue to conclude that a default for Greece is an inevitability and a question of when rather than if," said Nick Stamenkovic, strategist at RIA Capital Markets.

The euro zone ministers were expected to discuss ways to leverage their EFSF bailout fund, without reaching a conclusion on Monday, and put more pressure on Greece to implement agreed structural reforms and privatizations to try to get its economy growing again.

"We will be pressing the Greek finance minister to do some more tough talking about the implementation of reforms at home," said one euro zone official involved in the preparation of the meeting. "Greece would be well advised not only to announce but also to implement reforms."

The Greek government expects the economy to contract by 5.5 percent this year and a further 2.5 percent in 2012, when the original rescue plan anticipated a return to modest growth.

The projections illustrate a vicious spiral of recession, falling government revenues, soaring unemployment and declining consumer purchasing power into which Greece has fallen.

Officials expect the next aid tranche will be paid, because the euro zone will not be ready to cope with the fallout of a Greek default until its bailout fund, the European Financial Stability Facility (EFSF), gets its new powers of market intervention ratified in the next two weeks.

Even then, however, while the 440 billion euro fund will be able to buy government bonds from the market, recapitalize banks and extend precautionary credit to sovereigns, it may not have enough cash to cope with all the financing needs.

The leveraging idea, suggested by the United States, has opponents in north European creditor countries, who fear it could lead to bigger liabilities beyond the 780 billion euros in current EFSF guarantees, or credit rating downgrades for either the AAA-rated rescue fund or its triple-A guarantors.

Among the ideas under consideration is allowing the EFSF to refinance itself at the ECB's liquidity operations for banks. The EFSF could also guarantee to cover a percentage of potential losses investors could incur in case of a hypothetical sovereign default.

Any solution, however, should not require another round of ratification, officials said, because policymakers realized how difficult and lengthy the process was given the growing opposition to bailouts in many euro zone countries.

(Additional reporting by Ingrid Melander and Lefteris Papadimas in Athens, William James in London,; Writing by Paul Taylor, editing by Mike Peacock)

* The Institute for Supply Management releases at 1400 GMT its September manufacturing index. Economists expect a reading of 50.5 versus 50.6 in August.

* Chipmaker Intel Corp is to acquire mobile navigation software maker Telmap, the chief executive of the Israel-based company said on Sunday.

* The Commerce Department releases August construction spending figures at 1400 GMT. Economists predict a drop of 0.3 percent, compared with a 1.3 percent fall in July.

* Barclays and Bank Of America are looking to sell their stakes in apartment company Archstone, a source familiar with the matter said on Sunday.

* President Barack Obama may send to Congress as early as Monday three long-stalled free trade agreements with South Korea, Panama and Colombia, a senior administration official said on Saturday.

* Oracle chief executive Larry Ellison unveiled new all-in-one data center products as the world's No.3 software maker steps up its move into hardware.

* Eastman Kodak shares lost more than half their value on Friday after the company hired a law firm well-known for bankruptcy cases, triggering speculation the photography pioneer could file for bankruptcy.

* China's factory activity picked up in September for a second month in a row and export orders strengthened, offering reassurance that the world's second-largest economy can weather global economic turmoil.

* European shares were 2.4 percent lower on Monday morning after draft budget figures showed Greece would miss a deficit target set just months ago in a massive bailout package, showing drastic steps taken to avert bankruptcy may not be enough.

* European Central Bank member Christian Noyer said on Monday it is unrealistic to expect an increase in Europe's bailout fund beyond what was agreed in July, but that he is open to schemes that would allow leveraging to expand capacity.

* U.S. stocks ended their worst quarter since the depths of the 2008 credit crisis, crippled by Europe's debt debacle, a U.S. credit downgrade and a sputtering global economy.

* The Dow Jones industrial average dropped 240.60 points, or 2.2 percent, to 10,913.38 on Friday. The Standard & Poor's 500 Index fell 28.98 points, or 2.5 percent, to 1,131.42. The Nasdaq Composite Index lost 65.36 points, or 2.6 percent, to 2,415.40.

(Reporting by Atul Prakash; Editing by Dan Lalor)

Similar figures for Europe and the United States later on Monday are expected to underscore the gloomy outlook for the global economy.

A gauge of India's manufacturing output recorded its biggest monthly decline since November 2008 while Taiwan's factory activity slowed to a 32-month low, purchasing managers' indexes released on Monday showed.

Even in China, which reported a slight uptick in its official PMI on Saturday, economists saw evidence of a cool-down. China's factory activity typically rises in September as businesses prepare for the Golden Week holiday, but this year's increase was smaller than the average.

The HSBC Markit India Manufacturing PMI fell to 50.4 in September from 52.6 a month earlier, perilously close to the 50 mark dividing growth from contraction.

India's factory sector has gone from robust growth to near stall speed in just five months. A fall in the new orders index for the sixth straight month suggested more weakness ahead.

Taiwan's PMI dropped to 44.5, its fourth consecutive month below the 50 line. New orders contracted for a third straight month, with both domestic and overseas demand weakening in a sector that is closely watched because many of the island's tech firms make up integral parts of global supply chains.

"New orders from Europe were particularly mentioned as having declined," HSBC said in a statement.

Asia's stock markets tumbled on Monday, with Hong Kong shares taking a particularly hard beating. Analysts said foreign fund managers sold to boost cash, expecting a surge in clients' redemption requests. Worries about slowing Asian growth also weighed on sentiment.

Asia's export orders have been falling steadily since mid-summer as Europe's debt crisis intensified and the U.S. economy slowed. So far, the data points to a moderate slowdown in China and other Asian economies, but another U.S. or European recession would change the equation.

"A recession in the global economy could cause a China hard landing," Barclays Capital economists wrote in a note to clients, adding that this was not their baseline forecast.

Nomura economist Zhiwei Zhang said a new export orders reading of 50.9 in China's official PMI was well off the historical September average level of 55.7, excluding an unusually weak print from September 2008 when Lehman Brothers collapsed.

Europe's survey due later on Monday is likely to confirm factory activity contracted, while the U.S. index is expected to hover just above 50, a Reuters poll of economists showed.

In Japan, a similar report on Friday showed the manufacturing sector contracted in September for the first time in five months, suggesting that its economy was back in the doldrums after a short-lived earthquake-recovery boost.

Japanese business sentiment recovered somewhat in the third quarter, but a strong yen and Europe's debt crisis left companies cautious about the outlook, the Bank of Japan's quarterly tankan survey showed on Monday.

If there is a silver lining for Asia, it is that slowing growth has helped to cool inflation, which remains well above target in countries including China and India. Input prices in those two countries rose at a slightly slower pace in September, the PMI surveys showed.

That takes some pressure off the People's Bank of China and Reserve Bank of India to keep ratcheting up interest rates.

"While the persistent inflation pressures support RBI's tightening bias, the slowdown in manufacturing growth suggests that the end to the tightening cycle is at least now in sight," HSBC economist Leif Eskesen said.

(Reporting by Yati Himatsingka in Bangalore, Leika Kihara and Tetsushi Kajimoto in Tokyo; Editing by Neil Fullick)

The dire forecasts came while inspectors from the International Monetary Fund, EU and European Central Bank, known as the troika, were in Athens scouring the country's books to decide whether to approve a loan tranche. Without that installment, Greece would run out of cash as soon as this month.

The 2012 draft budget approved by cabinet on Sunday predicts a deficit of 8.5 percent of gross domestic product (GDP) for 2011, well short of the 7.6 percent target.

The 2012 deficit is set to meet a nominal target of 14.6 billion euros, but at 6.8 percent of GDP it falls short of a target of 6.5 percent, because the economy will shrink further.

"Three critical months remain to finish 2011, and the final estimate of 8.5 percent of GDP deficit can be achieved if the state mechanism and citizens respond accordingly," the Finance Ministry said in a statement.

European officials are scrambling to avert an abrupt Greek bankruptcy, which would wreck the balance sheets of European banks, jeopardise the future of the single currency and potentially plunge the world into a new global financial crisis.

European Union officials say the troika's assessment of Greece's future prospects could determine whether it needs to demand more debt relief from private creditors, a measure that could effectively amount to default.

In Sunday's documents, GDP is predicted to fall by 5.5 percent this year. Government sources said it was expected to shrink 2-2.5 percent next year.

Those numbers are in line with recent forecasts by the IMF, but much worse than predictions used to calculate a 109 billion euro ($146 billion) bailout in July, which anticipated Greece posting 0.6 percent growth next year.

The shortfall in the 2011 deficit target means Greece would need almost 2 billion extra euros just to finance its expenses for this year. It also means additional emergency tax hikes and wage cuts announced in the past two months to hit the target have not been enough to put Greece's finances back on track.

"The vicious circle continues for the government," said Yannis Varoufakis, economic professor at Athens University. "We have disappointing revenues, missed targets and this will bring new measures and new austerity."

To persuade the troika to release the next tranche of loans, Greece has promised to raise taxes, cut state wages and speed up plans to reduce the number of public sector workers by a fifth by 2015.

The cabinet approved a particularly contentious part of the plan on Sunday, creating a measure to reduce the number of state workers, a legal and political minefield in a country where government jobs are explicitly protected by the constitution.

The measure adopted by the cabinet on Sunday creates a "labor reserve" allowing 30,000 state workers to be placed on 60 percent pay and be dismissed after a year.

But the government softened the blow -- and saved less money than troika inspectors initially sought -- because about two-thirds of the workers would be near pension age and due to retire soon anyway. The rest would be from state firms that would merge or shut down.

Euro zone finance ministers are expected to discuss Greece at a meeting in Brussels on Monday, but will be waiting for the troika inspectors' report before taking any new decisions.

The inspectors are widely expected to give a green light to the release of the next 8 billion euro tranche of aid to avoid plunging the euro zone deeper into turmoil. But all eyes will be on their forecasts for 2012-2014.

If the inspectors conclude Greece's recession will continue to be worse than predicted, EU officials have suggested banks that agreed to write off 21 percent of the value of their Greek debt holdings in July may be forced to take deeper losses.

UNPOPULAR AUSTERITY

The austerity measures are deeply unpopular, and public sector unions hope a campaign of strikes and demonstrations can wreck the Socialist government's resolve to enact them. Striking civil servants have disrupted the talks with the troika over the past days by blockading ministries.

The government has a majority of just four seats in parliament and could be forced into elections if a handful of lawmakers balk. But disgruntled legislators have toed the party line over the past weeks and analysts expect them to continue to do so and pass the austerity budget.

"We have a single and steady goal -- to meet our commitments so that we guarantee our credibility," Greek Prime Minister George Papandreou told his cabinet, according to a statement from his office.

The inspection visit, which is expected to last well into this week, also focuses on budget plans for 2012-2014 and commitments to raise 50 billion euros from privatisations by 2015 and open up the country's heavily-regulated economy.

(Additional reporting by Lefteris Papadimas and Renee Maltezou; Writing by Peter Graff and Ingrid Melander)